Anker, Hymes & Schreiber, LLP

Before an entertainer decides to incorporate, he/she must first evaluate the application of Internal Revenue Code Section 269A. This section can be debilitating to the tax benefits of incorporating. Section 269A addresses the PSC and the services performed by it.

§ 269A(a): “If (1) substantially all of the services of the personal service corporation are performed for (or on behalf of) 1(sic) other corporation, partnership or other entity, and (2) the principal purpose for forming, or availing of, or such personal service corporation is the avoidance or evasion of Federal income tax by reducing the income of, or securing the benefit of any expense, deduction, credit, exclusion, or other allowance for, any employee-owner which would not otherwise be available, then the Secretary may allocate all income, deductions, credits, exclusions, and other allowances between such personal service corporation and its employee-owners, if such allocation is necessary to prevent avoidance or evasion of Federal income tax or clearly to reflect the income of the personal service corporation or any of its employee-owners.”

These words empower the government to disregard all of the tax planning done by the employee. If the government feels that “substantially all” of the income of the employee is from one source, the tax benefits afforded the loan-out corporation can be set aside. This issue was addressed by the United States Court of Appeals for the 8th Circuit in Sargent v. Commissioner of Internal Revenue. The case involved a hockey player who incorporated in order to place money in a pension plan for himself.

As discussed above, § 401 of the Internal Revenue Code allows for the corporate retirement plan contribution to be deducted by the corporation while not constituting income to the employee until the money is distributed by the plan. The hockey club contracted with Sargent’s PSC for his services and paid the corporation its contractual fee. The IRS issued a tax deficiency notice to Sargent for unpaid taxes, which was appealed to the Tax Court for consideration.

The Tax Court agreed with the IRS that the corporation set up by Sargent was merely a form of assigning income to the corporation and that Sargent was still liable for the taxes. The issue in the Tax Court was whether Sargent was an employee of the hockey team or his PSC. If he was an employee of the PSC, then the deductions taken for pension plan contributions were allowable. If he was an employee of the hockey club, then his pension plan contributions were not deductible, and the income from the hockey club would be attributed to Sargent as an individual and not to his PSC.

This is part of fourth section of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the corporate retirement plan.

A corporate retirement plan may include a pension plan, profit-sharing plan or combination of both. A pension plan is “established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to his employees, or their beneficiaries, over a period of years (usually for life) after retirement.” (Blacks Law Dictionary)

A profit-sharing plan is established and maintained by an employer to provide for the participation in the profits of the company by the employees or their beneficiaries. A corporate retirement plan may be qualified or non-qualified in order to take advantage of the tax benefits available. If the corporate retirement plan is qualified according to § 401, special tax status attaches. First, the amount of the contribution will be deductible to the corporation under §404(a)(1) for pension plans and § 404(a)(3) for profit-sharing plans. Second, “Any amount actually distributed to any distributed by any employees’ trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed”. (§ 402 Supp., 2000) Therefore, § 402 provides for tax deferral until the corporate retirement plan distributes to the beneficiary. For example, if a corporation makes a $10,000 contribution to a corporate retirement plan in the name of the individual employee, the corporation will be allowed to deduct this amount from taxable income and the individual will not be taxed on this amount in the year of the contribution! The contribution is placed into the corporate retirement account where it appreciates tax-deferred; the individual will be taxed on the amount when the retirement account distributes its corpus to the individual participant.

For the noncorporate taxpayer, usually a member of a union pension plan, the only deductible retirement contribution available would be an Individual Retirement Account (IRA). The deductibility of IRA contributions is limited when the individual is an active participant in a retirement plan maintained by an employer. For such individuals the IRA contribution is phased-out at certain AGI levels ($31,000-$41,000 for 1999).

Therefore, the noncorporate taxpayer may not receive the current tax benefit of the contribution because the contribution will be made with after-tax earnings. The corporate retirement plan has no comparable limitation.

This is also part of third section of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the alternative minimum tax and its effect on medical and miscellaneous itemized deductions.

An additional issue with regard to the deductibility of both medical and miscellaneous itemized deductions is the imposition of the Alternative Minimum Tax. “Congress enacted the alternative minimum tax (AMT) in 1969 to make wealthy taxpayers pay their fair share instead of using tax shelters and other means to reduce, or even eliminate, their federal tax liability.” (Kern, 1999). “The alternative minimum tax generally can be described as a flat tax rate which is imposed on a broader income base than the taxable income yardstick used for the regular corporate tax.” (Lind, supra note 11 at 15). “The tax is designed to ensure that all taxpayers pay at least a minimum amount of taxes.” (Blacks Law Dictionary, 1990). “Without the alternative minimum tax, some of these taxpayers might be able to escape income taxation entirely. In essence, the AMT functions as a recapture mechanism, reclaiming some of the tax breaks primarily available to high-income taxpayers, and represents an attempt to maintain tax equity.” (Commerce Clearing House, 1999).

The AMT is paid in addition to any other income tax imposed and calculated as the excess of the tentative minimum tax for the taxable year over the regular tax for the taxable year. The definition for tentative minimum tax, though, depends on the status of the taxpayer, whether noncorporate or corporate. The tentative minimum tax for the noncorporate taxpayer is the sum of 26% of so much of the taxable excess as does not exceed $175,000 plus 28% of so much of the taxable excess as exceeds $175,000. The Internal Revenue Code also provides for tax exemption status, evidencing the congressional intent of taxing the high-income taxpayers. If the taxpayer’s taxable income does not exceed $45,000 for taxpayers filing a joint return, $33,750 for the individual taxpayer, or $22,500 for the married taxpayer filing separately, the taxpayer is exempt from alternative minimum tax treatment. This means that, depending on the individual taxpayer, there could be an exemption from AMT for the lower income brackets. After the $33,750 exemption, the next $175,000 will be taxed at a rate of 26%. Taxable income exceeding this will be taxed at 28%. At the corporate level, the first $40,000 of taxable income is exempt from AMT treatment.

As previously discussed, the PSC will have little or no taxable income as a result of “zeroing-out.” Therefore, no discussion of corporate AMT is necessary.

When analyzing the application of AMT to the noncorporate taxpayer, the focus of the discussion turns to the medical and miscellaneous itemized deductions. For Regular Income Tax (“RIT”) purposes, medical expenses are deductible when they exceed 7.5% of adjusted gross income (“AGI“). For AMT purposes, medical expenses are deductible only when they exceed 10% of AGI. With regard to miscellaneous deductions, the difference between RIT and AMT is even more conspicuous. For RIT purposes, miscellaneous itemized deductions (specifically unreimbursed employee business expenses) are deductible to the extent they exceed 2% of AGI. Under AMT, however, miscellaneous itemized deductions are not allowed. This is significant since an employee working in a noncorporate structure will be considered an employee for whom she provides services.

Therefore, any business expenses she incurs will be considered unreimbursed employee business expenses, shown as miscellaneous itemized deductions subject to the 2% of AGI limitation and rendered non-deductible for AMT purposes. Under the PSC, these business expenses escape both the RIT limitation and the AMT exclusion.

* For specific inquiries regarding a business legal matter that you may have, you are welcome to visit our Tax Attorney in Los Angeles.

This is part of the third section of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the medical reimbursement plan and deduction limitations of the corporation and individual.

The corporation may establish a medical reimbursement plan as a benefit to its employees, which eliminates the medical expense deduction limitation. In a medical reimbursement plan the corporation will reimburse the entertainer/employee/shareholder for expenses incurred in securing medical treatment. When the corporation reimburses the employee for the medical expenses incurred, the employee avoids the limitation on the deductibility of medical expenses.

Furthermore, the employee avoids taxation on the reimbursed amount under Internal Revenue Code § 105 which provides that “gross income does not include amounts paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care … of the taxpayer, his spouse, and his dependents.” The effect on the corporation is equally beneficial to the corporate taxpayer in that “payments pursuant to a medical reimbursement plan by the employer corporation are deductible as a business expense.” (Berwind, 1985)

Using the previous example, all $25,000 in medical expenses would be specifically excluded from the gross income of the employee and would be deductible to the corporation; this saves approximately $12,500 in tax to the employee as an individual taxpayer.

Therefore, there is a definite tax benefit to the incorporated employee in the form of increased deductibility of expenses-deductions which may be limited to the individual taxpayer.

* For specific inquiries regarding a business legal matter that you may have, you are welcome to visit our Los Angeles Business Lawyer services page.